The Conservatism Principle and the

Asymmetric Timeliness of Earnings

An Event-Based Approach
Shroff, Venkataramanand, Zhang (2013)

Marina Fecke, Sven Wernicke

Content

Introduction
Motivation & Research Questions
Assumptions
Empirical Results
Summary and Conclusion
Comments
Introduction
Conservatism principle: anticipate no profits, but anticipate all losses, in doubt
choose the solution that will be least likely to overstate assets and income
accounting practice prefers skepticism in recognizing gains attached with
uncertainty

Asymmetric timeliness: relates to when the information of an economic event or

shock is recorded in periodic accounting earnings
earlier if it conveys bad news and
later if it conveys good news

Dual effects of asymmetric timeliness:

i. bad news should have a higher correlation with earnings of the concurrent
quarter relative to good news, and
ii. good news should have a higher correlation with subsequent earnings
Reasons for testing the asymmetric timeliness
Concept of materiality is a key factor governing the decisions of managers,
auditors, litigators, and regulators

Threat of litigation leads to conservative reporting, since the likelihood of litigation

is higher when earnings and net assets are overstated rather than understated

Goal of the paper: verify the hypothesis of asymmetric timeliness

Develop powerful tests of the asymmetric timeliness hypothesis by focusing on
extreme events
test whether information reflecting bad news is incorporated in
accounting earnings earlier than information reflecting good news

Central research questions:

i. Is bad news incorporated in accounting earnings earlier than good news?
ii. Is the accounting recognition of good news delayed until subsequent quarters?
General assumptions (I)
Identification of good and bad news: by extreme stock return behavior based on a
uniform cutoff for all firms as well as a firm-specific cutoff.
Good (bad) news is defined as the three-day market-adjusted return
i. greater (less) than or equal to 10 % (-10 %) during a quarter, or
ii. greater (less) than or equal to the mean plus (minus) 2.58 times the standard
deviation of three-day market-adjusted returns

Non-aggregated returns are beneficial:

aggregate returns net off good news and bad news shocks during an interval
impair the researchers ability to detect asymmetric timeliness
General assumptions (II)

Assumption of a (semi-strong) market efficiency:

economic shock occurs, the market reacts to it immediately
unusually high low returns over a three-day interval capture information in
an economic event or shock that has just been revealed

Event-perspectiveness:
take an event perspective rather than study the association between
accounting earnings and contemporaneous returns
Data

Initial dataset
all firms with data available on CRSP and COMPUSTAT databases over 1982-2007

Final Sample (1987-2007)

Period from 1982-1986
(91,500 firm-quarter observations)

Estimate the mean and the standard 65.8 % of them are good news
deviation of three-day market- 34.2 % of them are bad news
adjusted returns for each firm
Empirical procedure

The analysis is done in the following steps:

i. Extreme events and concurrent earnings changes

ii. Effect of other returns and incremental

iii. Extreme event returns and subsequent earnings changes

Extreme events and concurrent earnings changes
(I)
First step:
Test whether bad news is incorporated in accounting earnings earlier than good news

Regression using the combined good news and bad news sample:

where
: EPS of quarter t of year minus the EPS of quarter t in year 1 of firm i, deflated by
price at the beginning of quarter t
: extreme three-day market-adjusted return of firm i occurring during quarter t
: coefficient measuring the impact on accounting earnings of value-relevant information
conveyed by extreme positive returns,
: differential coefficient on extreme negative returns

Expectations: is expected to be positive and significant if bad news is recognized

earlier
Extreme events and concurrent earnings changes
(I) - Empirical results

Insight: Bad news are recognized

earlier than good news

(2 + 3 )
=
2
Extreme events and concurrent earnings changes
(II) Explanatory power
Second step:
Compare the explanatory power of bad news versus good news for earnings changes
Separate regression for the good news and bad news sample:

Expectations: and are expected to be higher for the bad news sample

Insight: Bad news have higher explanatory

power on the earnings changes of the
concurrent quarter
Effect of other events and incremental
Third step:
Capture the effect of other events and estimate the incremental effect (unique
variation explained by the extreme event)

Separate regression for the good news and bad news sample:

where = other returns, or the market-adjusted return of firm i for quarter t excluding the extreme returns

Expectations: impact on accounting earnings of extreme bad news as indicated by the

incremental is significantly higher than the impact of extreme good news.
Effect of other events and incremental
Insight: Incremental is significantly higher in the
- Empirical results negative news sample relative to the positive news
sample
higher explanatory power of the extreme returns
in the bad news sample
Including increases the explained variation
of the model

Incremental 2 : difference of 2 from the two regressions estimated for each sample
Extreme event returns & subsequent earnings
changes
Fourth step:
Test whether accounting recognition of good news is delayed until subsequent quarters

Regression using the combined good news and bad news sample:

where
+,+ : change in EPS for the period comprising quarters t + 1 to t + j (j = 1,..,3), deflated by
price at the beginning of quarter t (change in EPS is calculated relative to the same quarter of
previous year), : extreme three-day market-adjusted return of firm i occurring during quarter
t, : coefficient measuring the impact on accounting earnings of value-relevant information
conveyed by extreme pos. returns, : differential coefficient on extreme negative returns
Expectations:
is negative and significant, if more good news relative to bad news is
incorporated in accounting earnings of subsequent quarters
If negative news is incorporated earlier than positive news, we expect a higher
correlation between subsequent quarters earnings changes and extreme returns
of quarter t for positive news firms relative to negative news firms
 Extreme event returns & subsequent earnings
changes - Empirical results

Insight:
mean estimate of the differential coefficient on negative extreme returns, , is
negative but insignificant in the subsequent quarter
negative and significant when earnings changes are cumulated over the subsequent
two and three quarters
s with respect to all subsequent quarters are significantly higher for the positive news sample
Summary and conclusion
Goal: Test whether bad news are incorporated in accounting earnings on a more
timely basis than good news

Use extreme returns to identify good bad news

Negative extreme returns have a significantly higher explanatory power for
concurrent earnings changes than positive extreme returns
The impact of good news on accounting earnings is delayed by at least a quarter
relative to the impact of bad news
No significant asymmetric effect of good and bad news on cash flows

Result:
Consistent evidence of the dual effects of asymmetric timeliness in the reporting
of quarterly earnings, but no evidence in operating as well as free cash flows
Contribution to literature
Modification of Basus methodology:
Previous results
Contemporaneous quarter: Application of annual or quarterly aggregated date
yields a significant and negative coefficient for positive news which is hard to
interpret (e.g. Basu, Hwang and Jan (2003)).
Subsequent quarters: Returns over longer periods (2 or 4 years) as explanatory
variable yields negative coefficient on positive returns (e.g. Ball et al. (2000),
Basu (1997)). Pope and Walker (1999) include legged returns and observe
positive differential coefficient for lagged returns. However, it decreases with
longer lags.

Innovation
First to directly test effect of returns with subsequent quarters.
Application of extreme 3-day market-adjusted returns as proxy for news.

Methodology can be applied to situations where tests have failed to identify

asymmetric timeliness using the traditional approach.
Critique
General
+ Account for many factors that could bias results (e.g. exclude earnings announcement,
seasonality effects, test if different results in first and second half of data, etc.)
+ Account for company size (deflate EPS by stock price)
+ Exclusion of market effects & trim at 1% quintile
- Means and standard deviations based on the period of 1982-1986 bias
- Identification of the bad and good news events

Identification of the bad and good news events

- In case of several separated good/bad news aggregated effect reduces the

differential timeliness measure
- Deletion of quarters with mixed news miss important observations
- Inconsistency if we (partly) use returns over more than three days
Alternative interpretation
Suppose managers strategically disclose information to the market.
Observed pattern is a result of their news dissemination strategy delaying the
announcement of bad news to market until its disclosure in earnings is imminent,
but disclosing good news some periods prior to its recording.

Practical implications
Asymmetric timeliness implies that the income and capital tends to be lower /
underestimated

Relevance for functioning capital markets:

Does conservative reporting lower the accounting quality, especially in M&A
processes?
Thank you for your attention!